Accounting , Finance

Are Exchange-Traded Funds Dumbing Down the Markets?

These investments, now more popular than hedge funds, come with a down side.

August 24, 2015

| by Edmund L. Andrews

A picture of a stock market ticker

Researchers found that exchange-traded funds, an increasingly popular investment vehicle, increase the volatility of the underlying individual stocks. | REUTERS/Kai Pfaffenbach

Over the past decade, no investment vehicle has enjoyed more explosive growth than the robot-like exchange-traded funds, or ETFs.

ETFs are simply baskets of stocks that automatically mimic a particular index, from the broad S&P 500 Index to scores of narrower indexes on everything from small-cap tech stocks to precious metals and real estate stocks. They’re attractive to investors because they offer great diversity, yet are inexpensive and simple. Whereas a traditional, managed mutual fund might charge 2% a year in fees, an ETF charges as little as 0.1%.

And because research has shown few actively managed mutual funds actually outperform the market averages on a regular basis, legions of investors have abandoned the middleman and moved to ETFs. In the past five years alone, the assets of ETFs have tripled from about $1 trillion to $3 trillion. This summer, in fact, ETFs for the first time attracted slightly more money than once-glamorous hedge funds.

But a new paper co-authored by Charles Lee, a professor of accounting at Stanford Graduate School of Business, finds that the boom in robo-funds may end up dumbing down the stock market as a whole.

The researchers found that ETFs increase the volatility of the underlying individual stocks and raise transaction costs for active investors who want to make bets based on their own research and analysis. As a result, ETFs reduce the returns to “alpha-seeking” investors who put time and money into acquiring knowledge that gives them an extra edge.

Given all the skepticism about high-priced portfolio managers, that may not sound like a problem. But Lee argues that the accuracy of market pricing ultimately requires good information, which in turn requires people who are willing to dig for information, develop sophisticated background knowledge, and conduct hard-headed analysis.

“We need to remember that markets don’t correct themselves,” Lee argues. “The price of a stock is only right because some investors are expending resources to acquire information about each company. In other words, there is also a market for information on individual companies, which only functions properly when costs of acquiring better information are balanced by the benefits. Our findings suggest the growth of ETFs is increasing the costs and reducing the benefits of information acquisition. And if everybody is buying passive funds, nobody will be out there to make sure that the prices are right.”

The Data

The new paper, which Lee co-authored with Doron Israeli at the Arison School of Business in Israel and Suhas Sridharan at UCLA’s Anderson School of Management, documented striking effects of ETFs in both increasing the trading cost and decreasing the information value of prices in the underlying stocks.

The researchers examined the stocks of nearly 7,500 publicly traded companies from 2000 to 2014.

Not surprisingly, they found that the share of ETF ownership in companies has skyrocketed — from about 0.1% on average in 2000 to 7% in 2014.

If everybody is buying passive funds, nobody will be out there to make sure that the prices are right.
Charles Lee

More important, the researchers found that stock “liquidity,” the shares available for trading at reasonable cost, had decreased in stocks that were heavily owned by ETFs. That in turn increased the cost of buying and selling the individual underlying shares, as reflected in the spread between bid and ask prices offered by traders. A wider bid-ask spread means higher transaction costs for buyers and sellers. On average, the researchers found, companies with high levels of ETF ownership — defined as 3% or more of a company’s shares — had bid-ask spreads that were 6.4% wider.

That wasn’t all. The researchers also found that stocks with high ETF ownership were more likely to move in response to broad trends rather than to specific information about the companies themselves. Stock-return “synchronicity,” a measure of how much a stock moves in tandem with the market and with other stocks in the same industry, was 45% higher for companies with high ETF ownership.

In fact, the researchers found that firms with high ETF ownership were followed by fewer Wall Street analysts, and that the number of analysts who followed a stock declined as the ETF ownership went up. On a technical level, the researchers found that the stock returns at a company with high ETF ownership were also less reliable predictors of the company’s future earnings.

Diverging from Hedge Funds

One might reasonably wonder: Why would ETFs have a different effect than traditional mutual funds or hedge funds? Those institutions buy and sell huge baskets of shares, too, and many hedge funds are driven by their own robot-like trading algorithms. Yet the study finds that institutional ownership by these funds does not have the same detrimental effect on stock liquidity and pricing efficiency.

Lee says one key difference is the unprecedented appeal of ETFs to uninformed traders. Unlike a traditional mutual fund, which can only be bought once a day, an ETF is structured so that it can be bought and sold all day long — like an individual stock. ETFs are also typically low-cost, tax-efficient, and offered in small enough units to appeal to small investors. For these reasons, they are particularly attractive to uninformed traders who would otherwise trade the underlying component securities.

Lee’s immediate concern is that ETFs will dumb down financial markets by reducing the benefits of hunting for cutting-edge information and insight. If that happens, stock prices will become less accurate barometers of corporate prospects.

Lee also has longer-term concerns. Because of the way ETFs are structured, they provide an easy way of investing in otherwise hard-to-trade assets. The downside is that investors could increasingly bet on an index without buying any actual shares at all — much the way that Wall Street firms began trading “synthetic” mortgage-backed securities that simply mirrored mortgage-market indices.

Lee doesn’t argue that individual investors should abandon ETFs. For people who don’t want to do their own research, ETFs still offer a very inexpensive way to build a diversified and customized portfolio.

“All of this is really good, especially for small investors,” he says. “But we should also recognize that nothing is free and there may be another shoe to drop.”

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